A better Way to Buy Health Care: How Would You Like a $2 Pizza?

August 10, 2009

For release Aug. 12 and thereafter (652 words)

Arthur Laffer’s most famous contribution to public policy is said to have been delivered on the back of a paper napkin. The “Laffer Curve” illustrates the necessary relationship between marginal tax rates and tax revenues — that higher tax rates raise more revenue, but only up to a point. After reaching that level, higher rates will reduce the revenues taken by the government.

In the early 1980s, when the top marginal tax rate was 70 percent, President Ronald Reagan and a Democratic Congress reasoned that lower tax rates would stimulate an economy with unemployment rates higher than what we see today. The result was a tremendous economic expansion and far more tax revenue for the federal government.

Dr. Laffer has remained active since then. His most recent project is an effort to estimate the impact of legislative proposals on healthcare costs and taxpayers at the national and state levels.

In the recent report by Arduin, Laffer & Moore Econometrics, the economists estimate the impact of the $1 trillion proposal to increase federal government health subsidies over the next decade.

They find that:

Medical price inflation would be 5.2 percent higher than without the proposal—driven by the increased demand for services.

Federal taxes would increase by $15,600 for the average family of four.

Indiana state income taxes would increase by $1,400 for the average family of four—because of the additional medical price inflation and some burden-shifting by the federal government to the states.

The average cost of insuring the 16 million additional people will be $62,500 per person over the decade. (The $1 trillion proposal does not address the other 30 million who would still be without insurance.)

Laffer and his associates also bring one other important set of numbers to the table. In describing the current problems in healthcare, they note a price “wedge” between consumers and producers.

First, consider a standard market — for example, pizza. There is no wedge in this market because you pay $10 for a pizza and the pizza producer receives $10.

In healthcare, there are “third-parties” involved — so that the cost of the service to you is (far) less than the payment received by the service provider. By analogy, your $10 pizza might only cost you $2, because the remaining $8 is paid by the government or your pizza insurance.

The pizza provider enjoys this arrangement. (He still receives his $10.) And you are happy — unless the insurance company or the government tells you which toppings you can have or whether you can have pizza at all. Taxpayers probably won’t notice — unless the government suddenly wants to commit to buying a lot more pizzas for other people with their money. In any case, this is far from optimal since buyers will be artificially eager to devote the resources of others to purchase stuff for themselves, leading to all sorts of inefficiencies.

Laffer’s study notes that this “wedge” in healthcare has grown over time. Over the last 40 years or so (and using round numbers), out-of-pocket spending for consumers has fallen from 50 percent to 10 percent. (In other words, the price of your pizza fell from $5 to $1 — for you.) The proportion picked up by insurance increased from 25 percent to 40 percent. (This is one significant reason for higher insurance premiums.) And the proportion picked up by taxpayers rose from 25 percent to 50 percent.

Going forward, two questions should dominate the healthcare debate: Is it better to increase or decrease this “wedge”? And is it better to have a single, grand, federal experiment — or to try 50 different plans at the state level?

D. Eric Schansberg, Ph.D., is a professor of economics at Indiana University Southeast in New Albany and an adjunct scholar of the Indiana Policy Review Foundation. He is the author of Turn Neither to the Right nor to the Left: A Thinking Christian’s Guide to Politics and Public Policy and the editor of SchansBlog.

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